The big disconnect between leverage and spreads

Matt King from Citigroup usually serves up nice presentations, but his past few highlighting the increasingly problematic increase in leverage among non-financial corporates are particularly illuminating. The latest installment is full of illuminating charts, but it will suffice to focus on the one below,

Source: Citgroup, Matt King (March 2014)

Since 1988 there has been a relative close, and logical, correlation between higher corporate leverage and higher spreads, but not this time around. It is difficult to find a clearer picture of the effect of a structurally low interest rate regime (ZIRP) run simultaneously by global major central banks.

One of the most obvious consequences of persistently low interest rates in the past 2-3 years has been the increase in leverage for non-financial corporates (with access to the debt markets). A new bubble is brewing and if you look at the sectors of the economy that have responded to low interest rates (i.e. who have had room to lever up) the picture falls squarely on non-financial corporates.

Yet, when presenting this view to clients in the past 6-12 months I have received strong push back. Net debt is still low I am told and corporate cash balances have improved. All this is true, but I have already given a hint to my rebuttal. We need to look at non-financial corporates and indeed, we need to drill down to sector level.

First of all, let us quickly dispense with the notion that US corporates are sitting on large cash balances. This is true when judged from afar, but cash reserves are very concentrated.

The reason for this skew is mainly banks and the likes of General Electric, Berkshire Hathaway, Apple etc. This is simply to say then that the notion of US corporates being awash with cash does not hold up to scrutiny as a general market characteristic. This is supported by the expecteced relationship between higher net debt and a lower liquidity position (measured by the Quick Ratio).

So while the market based information is telling us that spreads and leverage are now disconnected, fundamentals remain in-line with theory. Companies with higher net debt also have poorer liquidity positions [1]. The final piece of evidence I would like to point to however is just distorted overall net debt data is by the financial sector.

Including the financial sector will consequently give a picture steadily declining leverage to new lows in the past 5 years. However, this is deeply misleading. If we strip out financials (which in any case is logical as their balance sheets look completely different from non-financial corporates’) net debt per share has ascended new highs in the past 2-3 years. Mind you, these figures are both indexed and inflation adjusted so there is no nominal money illusion to blame for the results either.

There are now more corporate bonds outstanding in the US than there are mortgage backed securities. This is a significant data point. The heart of the next crisis and debt bubble will be non-financial corporate debt (particularly in the energy and materials sector). Investors should take note.

—

[1] – The relationship between net debt per share and the Quick Ratio is non-linear due to the fact that the Quick Ratio is bounded by zero at its lower bound (while net debt per share is unbounded).